Brown mandates a 'greener' Golden State

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The following is a Viewpoint from Michael Ferguson, director of Sustainable Finance at S&P Global Ratings.

In September 2018, now-outgoing California Governor Jerry Brown, continued the state on its course to a sustainable future. He signed SB100: a mandate to keep California on a path to deriving 100% of its power from clean sources by 2045 — from today's figure of around 35%, while also setting a goal for a carbon-neutral economy during the same time frame.

Yet even the most ardent supporters of the mandate, which came on the eve of an international climate summit, must acknowledge the substantial technological and political hurdles it could still bring.

The first is overcoming the inherent reliability issues from intermittent renewable energy sources. In addition, the state must act on the landmark legislative change in the midst of environmental backsliding at the federal level, including the rollback of the Clean Power Plan and the announced exit from the Paris Agreement.

These challenges, though most likely surmountable, also could prompt significant credit implications for the state's power generators. As such, the significance of Governor Brown's legislative mandate cannot go understated.

Risks for gas-fired generators?

This holds particular truth for the state's incumbent gas-fired generators. Over the long-term, these assets already were facing significant threats to their market position, finances and credit stability. Though natural gas today contributes around one-third of California's power, demand has been floundering in recent years due to negative load growth and the rise of renewable sources.

The 100% goal will elevate these challenges to new heights. In fact, the economics of gas-fired generation is now less favorable than at any point in recent memory.

Some California-based merchant power generators have already shelved plans for new gas fired capacity, while their older assets are likely to be shuttered as progress toward the goal progresses, especially if net demand continues to be weak. This is even though the high renewable output can lead to strong peak pricing for gas-fired generators.

Further pressuring these assets are additional state policies and energy efficiency mechanisms designed to lower overall energy consumption, on top of changing economic conditions that have diminished demand. These measures are limiting peak pricing and the net capacity factor for fossil-fuelled generators.

Risks for traditional energy production assets may only intensify as their economic rationale worsens: there's a broad consensus that new gas-fired capacity in California now seems unlikely. Further, as the economic rationale improves for battery storage solutions, the gas-fired generators' last bastion — the guarantor of grid reliability — diminishes with it.

The renewables rally?

It goes without saying that SB100 is a boon for renewable energy assets in California. But it's a mistake to consider these benefits to be mutually interchangeable — instead some assets stand to benefit more than others.

While SB100 will naturally benefit existing solar and wind power, less obvious is by how much and when. Both asset types represent most renewable installations in the Golden State. Yet they are by no means immune from risk.

Under our project finance criteria, we consider existing solar and wind technologies to have 20-year lifespans. So, once incumbent wind and solar assets reach the end of their lifespan, developers must decide whether to repower them (specifically, aged turbines), or to replace them with advancing technologies. All of this can complicate the forecasting process as we seek to capture maintenance costs over a long asset life.

We see two further risks for existing projects. First, the goal set out by SB100 may prompt the State to eventually provide preferential pricing for newer assets (whether it be by power-purchase agreements or other incentives) — thereby presenting uncertainty to the incumbent grid.

A second consideration for the existing players is the State's drive toward reducing overall power consumption — a goal it has sought by limiting peak pricing and capacity factors for fossil fuel generators and introducing energy efficiency mechanisms. Those assets more exposed to refinancing risks may anticipate weakening project metrics as the asset life progresses. This could even give some — albeit temporary and fleeting — uplift for gas-fired generators.

Hydro and geothermal: the major beneficiaries

These risks in mind, the biggest winners could be hydro and geothermal assets. By contrast to wind and solar assets, intermittency is less problematic for these assets, which are closer to baseload.

A greater role for hydro and geothermal assets could, in turn, help solve the major issue that needs addressing: how to meet the lofty mandate while also guaranteeing the grid's reliability. Though solar and wind rely on plus-storage solutions, hydro assets have their very own "battery".

Helping the cause of hydro and geothermal assets is their longer anticipated asset lives. Hydropower plants, which produced approximately one-fifth of California's total in-state electricity last year, can run for more than 80 years. Many assets elsewhere in the country have far exceeded this longevity benchmark, thanks to considerable maintenance spending.

The capital costs for new hydro assets (but also for new geothermal assets) remain a drawback to expansion, however. Another consideration is the environmental disruption that building these assets can have in contrast to other assets, such as photovoltaic (PV) farms, for example.

In the absence of large (and unforeseen) incentives, any increases to the State's hydro capacity will likely be incremental, at best. Against this backdrop, California could also look to improve ties with its hydro-intensive neighboring states to the north or its solar and geothermal-abundant neighbor to the east, Nevada, with which it already participates in the Energy Imbalance Market, the country's first power trading market of its kind.

The "green rush"

Of course, California's green rush precipitates some vexing questions. How will new generation capacity be financed? Will the emergence of new yet less-tested models, such as distribution generation and community choice aggregation, affect access to debt markets? Who pays for it all: the generator; or the ratepayer? And can battery storage costs fall enough to appease the credit and reliability issues that have yet to be resolved?

At this point, it seems that the State has some way to go before it closes these issues. Nonetheless, this laudable decarbonization effort might not only signal a landmark for state-level energy policy — but for economic policy, too.

An executive order signed by Governor Brown also targets a carbon-neutral state economy by 2045, which will necessitate even harsher economic sacrifices. That said, the path to a greener future has been laid. As federal-level guidance on the matter retreats, the ambitions of the Golden State could be a beacon for other states to follow.